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Letters Of Credit And Performance Bonds

Foluke Akinmoladun

Okayplayer

  There is a significant amount of money involved in international trade, and many times, traders will have to take out loans or perform their end of the bargain on a promise to third party vendors to pay on a certain date.
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While this is a risky situation under any circumstance, it is even riskier under international trade law, where the parties to the contract are usually based in different countries, under different legal systems and trade jurisdictions. Sometimes, the parties to an international trade contract may have never met each other, and may never even meet each other throughout the duration of the contract. In order to conduct seamless international trade, there are certain instruments that are available to traders to enable them to conduct their business without having to bear the obvious risks involved. Among these instruments are letters of credit and performance bonds.

Letters Of Credit

A letter of credit is an instrument by which a bank undertakes to pay the seller (exporter) for his goods provided he complies with the conditions laid down in the credit. Whilst ensuring that the exporter receives payment for his goods, it also gives the buyer (importer) the confirmation that he will not have to part with his money until he is presented with documents evidencing that the stipulated conditions have been fulfilled. The letter of credit helps the parties to an international trade contract to overcome the risks associated with carrying on business from different jurisdictions, usually far away from each other. While the buyer is assured that payment will only be made to the seller upon the performance of the contract, the seller is assured, having performed his/her end of the bargain, that payment will be made at all. In addition to the buyer and the seller, two banks are involved in the insurance and payment of a letter of credit. They are the issuing bank (buyer’s bank in his/her country) and the confirming or correspondent bank (bank in the seller’s country). It is from the correspondent bank that the seller receives payment.

Characteristics Of Letters Of Credit

The two main characteristics of letters of credit are;
  1. They are autonomous: this means that the letter of credit is a separate and autonomous document or contract form the contract of sale and will not be affected by disputes relating to the contract of sale. Therefore, the banks will be obligated to fulfil their duties under the conditions of the credit facility once the collecting party (usually the seller) is in strict compliance with the terms of the credit documents.
  2. There must be strict compliance with their terms: this means that the performance of a letter of credit must strictly conform with the terms and conditions agreed by the party, and any discrepancy, no matter how slight, will justify a dishonour of the letter of credit.
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Types Of Letters Of Credit

  1. Revocable Credit: the credit under this form can be revoked by the buyer at any time so the seller has no guarantee that the bank will pay upon presentation of the agreed documents.
  2. Irrevocable Unconfirmed Credit: the credit here is revocable only upon agreement by the parties involved, so it cannot be unilaterally revoked by the buyer. However, this type of credit is not confirmed by the correspondent bank, so if payment is not made, the seller’s cause of action is against the issuing bank in a foreign country.
  3. Confirmed Credit: this type of credit is guaranteed by the correspondent bank so that if payment is not made from the issuing bank, the correspondent bank will pay the seller.
  4. Transferable Credit: this type of credit can be transferred, in whole or in part, to a third party, so the seller can transfer to anyone he/she wishes to. This is useful where the seller has transacted with a third party in the same transaction, so he/she can pay that party with the transferable credit issued to him/her.
  5. Stand-by Credit: this type of credit is based on a guarantee by the issuing bank that the buyer will pay so that if the buyer fails or refuses to pay, the issuing bank will pay the seller.
  6. Revolving Credit: this type of credit exists where there are ongoing transactions between the buyer and the seller, so they can use the revolving letter of credit several times for different transactions.

Performance Bonds

Performance bonds are usually used to secure the performance of the seller under a sale contract. In other words, performance bonds, are also frequently termed performance guarantees, provide security in the event of non-performance of the contract. Performance bonds are a newer development than letters of credit. They are guarantees issued by a bank at the commencement of a transaction to assure one of the parties that there will be the performance of the agreement, and in the event that there is a default or failure to perform, the bank pays the party to whom the guarantee was made. The performance bond is similar to a stand-by credit, in that it acts as a security for the transaction and not necessarily as a secure means of payment for the transaction. It is less popular and less developed than the letter of credit but remains a tool used to make international trade transactions less risky and more favourable.

Conclusion

Though a letter of credit is a guaranteed form of payment by a Bank, it is important that this assurance emanates from a “healthy” bank without any risk of insolvency. The presentation of forged documents, which is a major disadvantage, will most likely be forestalled if proper investigatory checks are carried out by the dedicated department of the advising and issuing Banks. Featured Image Source: Okayplayer
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